8/20/2009 @ 11:00AM

Cautious Buys in REITs

Real estate investment trusts have had a sizzling run-up from their March lows. Now what to do? Take some money off the table. Bargains are getting scarce. Since the market turned a corner, investors have euphorically scooped up shares of REITs that had fallen 70% and more from peak prices within the past two years. They’ve tolerated dilution and wolfed down $16 billion in new shares–with more share offerings on the way from some high-quality companies–as REITs rush to raise capital in a suddenly more salutary market environment.

If you followed my recommendations for companies such as Host Hotels & Resorts, Digital Realty Trust and Acadia Realty Trust, you’ve done just fine. These and others I recommended in my Mar. 16 column are up an average 75% (to the s&p 500′s 33%). But now the rationale for further appreciation is hard to swallow, even for these terrific companies. Those of you who got into the REIT sector earlier, to be sure, are hoping just to break even; my first REIT recommendations (May 5, 2008) are off 21% (versus the market’s decline of 27%). The full recovery to the peak prices of 2007 is still a long way off.

The reason for lightening up is that the fundamentals don’t look good. For office, industrial and retail properties as well as for apartment buildings, both rental values and occupancy rates are falling. The collapse of business and leisure travel has been devastating for hotels, which set rents on a daily basis.

While the underlying environment for these conditions is deteriorating more slowly than it has been, the kind of jobs-generating recovery that will fill office buildings and put money in the pockets of renters, shoppers and travelers remains elusive. Even when that recovery does arrive in earnest, its effect on real estate revenues will not be immediate.

The run-up in REIT shares since early March has not been irrational. Prices then were well below what REIT assets would have been worth in a liquidation. But beyond this point investors adding money to the sector are ignoring a threat: short-term maturities of loans financing hundreds of billions of dollars in commercial real estate loom over property owners whose holdings are losing value along with rental income. This situation could pull more banks and other companies underwater. An upheaval in capital positions would mean huge losses in market value not just for landlords but also for the pension funds that hold positions in commercial property.

Valuations of REITs much beyond where they are today anticipate a resumption of activity that is not going to materialize for at least 12 months, while the debt service and the rents under pressure are the harsh reality today.

REITs with good balance sheets, like those mentioned above, will be in a position to make deals with pressured owners and thus add income-producing properties at reasonable rates. Still, they are expensive. Digital Realty Trust, for example, is trading for 21 times the likely adjusted funds from operations it will report in 2009. (AFFO is essentially net income with depreciation added back minus capital expenditures and noncash revenue.)

A handful of REITs are cheap enough to buy now. If you are putting money into the sector, consider these:

Associated Estates Realty (AEC, 7.1), a multifamily REIT, owns blue-collar apartments in the Midwest. The management has done a great job rejuvenating its portfolio by cycling out of older buildings and into newer ones, while keeping occupancy rates high. AEC will either grow slowly as an independent or get bought when the recovery kicks in. AFFO should come in this year at 94 cents a share. The yield is 9.4%.

Then there’s the hapless hotel sector, where you have the highly anticipated $1.15 billion Hyatt new issue. This sale will bring public about 10% of the hotel company, which is majority-owned by the Pritzker family of Chicago. Tentatively priced at about $13 a share, Hyatt was originally going to go off at $29 before the market tanked. Hyatt is a premier name, but you can do better with an existing hotel company that has fallen out of favor.Hospitality Properties Trust (HPT, 17) recently boosted its balance sheet with fresh capital and is still trading on the low side, at 6 times 2009 AFFO. Also, I’m reversing myself on Sunstone Hotel Investors(SHO, 6.1), because new management has thought out how to cope with short-term challenges. That price is 15 times expected 2009 AFFO.